Political Distribution Risk and Business Cycles

By Thorsten Drautzburg, Jesus Fernandez-Villaverde and Pablo Guerron-Quintana

http://d.repec.org/n?u=RePEc:red:sed017:1201&r=dge

We argue that one important determinant of the variation in income shares is political risk. To that end, we document significant changes in the capital share after political events such as the introduction of right-to-work legislation in U.S. states and international events such as the Carnation Revolution in Portugal. These policy changes are often associated with significant fluctuations in output and asset prices. To quantify the importance of these political shocks for the U.S., we extend an otherwise standard neoclassical growth model. We model political shocks as exogenous changes in the bargaining power of workers in a labor market with search unemployment. We calibrate the model to the U.S. corporate non-financial business sector with a standard process for productivity. A one standard deviation redistribution shock reduces the capital share up 0.2 percentage point on impact and leads to a drop in output of 0.6 percent. Our calibration also implies that political distribution risk can explain 15 to 25% of the observed volatility of U.S. gross capital shares — and 35 to 45 percent of output volatility, depending on the elasticity of substitution between capital and labor. Eliminating political redistribution risk in the U.S. would raise the welfare of the representative household by 1.6 percent of steady state consumption.

I am actually surprised that political risk matters that little, at least for the US, seeing how politics can wreak havoc in other countries. Or maybe it is that bad politics is a steady state elsewhere, and thus it has an impact more on the levels than the fluctuations.

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